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How Banking Actually Works In Fiat World, Part 2

This is a follow up to the post How Banking Actually Works In Fiat World.

There was some confusion over the issue of the role 'reserves' play in the present monetary regime compared to that of the gold standard. This post hopes to clarify the issue.

Reserves are limited only by Federal Reserve policy. Having no intrinsic value or legal limitations, they are purely an instrument of policy with no inherent limit besides policy decision.


Under the traditional gold standard, a bank's cash liabilities (cash owed to depositors) were either gold proper or certificates redeemable in gold at a fixed rate. Whether the rate of conversion was set by the bank or by the state, the deposits were redeemable in gold coin or bullion.

Cash was gold, and the cash deposited with banks had to be backed by some reserve of gold or gold notes, generally fractional. I don't intend to argue the point, but I will just state that this was contractual, voluntary, and understood by any informed depositor, and was neither fraudulent nor illegal by any reasonable standard.

There was a time when banks actually issued their own bank notes to function like currency, and any major bank that was reputable could circulate its notes on par with face value, even though the gold reserve for redeeming these notes was at any given time only a fraction of the outstanding supply of bank notes. Banks had very pretty looking gold-backed notes that provided the template for future state currencies in many ways, in terms of design.

The banknote was a credit instrument in the same sense that today's checking account is 'bank money' or 'credit money;' all credit money is double entry bookkeeping: the loan that created it and the liability the loan produced.

The bank issued its notes as credit, and the recipient of the notes (the borrower) owed the bank what he promised to pay back. So the banknote that was issued to the borrower was created when the bank created a receivable asset, a loan. The banknote itself was a liability of equal value to the bank, to be redeemed to the note holder for cash (gold or gold certificates). Even before fiat, banking was the creation of credit, not the lending of stored funds.

Banknotes were not cash themselves, but they functioned like cash as long as public confidence in the notes was maintained. This depended on reputation, prudent management, etc. These are properties of the market and contractual arrangements. Nothing is 100% certain when relying on trust in others who are in a position to betray that trust without facing sufficiently deterrent consequences.

Because these notes were not cash, but redeemable in gold, the banks had to maintain a reserve of gold to handle redemptions. It had to manage its "liquidity." In a pinch, it would have to liquidate marketable assets (its receivable loans and other holdings) to raise cash demanded by noteholders and depositors.

At any one time, it could only redeem a fraction of outstanding liabilities with gold, and would have to raise the rest by selling assets.

That is why when a banks capital position (net worth) was in question, due to poor asset quality, and hence solvency in question, a bank could not raise the cash needed to cover withdrawals. Hence, banks runs and the instability this caused. Maturity transformation - the funding of long term loans with demand deposits or short term deposits - was also a factor in the instability.

In any case, the total outstanding banknotes or bank money (credit) was backed by a fractional reserve of physical money in the form of gold or other precious metals that formed the currency. That was the oft referenced "Fractional Reserve Banking" system of the gold standard era.


Today, there are neither bank notes nor gold reserves.

Today's parallel to bank notes is "check money," or the electronic balances bank customers hold over and above the "base money" - the present day equivalent of yesterday's gold reserves. These are no longer printed in the form of pretty banknotes, but exist as electronic, abstract "ledger entries," recording the amount of credit and the credit relationships of account holders.

Money in this sense is a record of credit agreements, of promises, obligations and debts between contracting parties. These records of promises are denominated in the official or legal unit of account of the day and the place - for us, the US dollar.

Most transactions take place in the form of this electronic money - changing ledger entries, reshuffling the relationship of obligations and balances between parties. These obligations are settled by crediting and debiting bank accounts - shifting balances between individuals and their banks, and changing ledger entries to record the transfers.


Today, bank reserves are the balances in accounts held at the Federal Reserve by Fed member banks. These reserves are transferred electronically, back and forth, to settle balances that accrue between bank account holders, and hence banks, due to credit transactions.

The Fed uses these reserves to set the overnight interest rate for the borrowing of reserves. Banks who have excess reserves above the requirement lend them overnight to banks who are below the requirement, at a market rate. This is the Fed Funds market and the Fed Funds rate.

If the banks have an excess of reserves, in aggregate, this rate will fall below the Fed's target rate. The Fed will then drain these excess reserves by selling treasury securities (govt bonds) to banks in "open market operations" (OMOs), temporary or permanent (TOMO or POMO).

If banks in aggregate are short of required reserves, the rate will be bid up above the Fed's target rate, and the Fed will add reserves by purchasing treasury securities (govt bonds) from the banks.

Banks manage their reserve position after the fact, as an afterthought to issuing new loans (creating credit by expanding both sides of the balance sheet, entering a new asset, the loan, and a new liability, the deposit). It is not a factor in their lending decisions.

If bank credit is growing (bank balance sheets expanding with new loans matched by new liabilities), banks will need new reserves in aggregate to stay within reserve requirements, and the Fed will add those reserves at whatever amount is necessary to hit their target FF rate.

If banks in aggregate are in excess of their required reserves, the FF rate will fall and the Fed will need to withdraw reserves to hit the target FF rate.

Likewise the Fed can choose to raise or lower the target FF rate. But at whatever rate it targets, it will provision or withdraw the amount of reserves necessary to hit the rate.

Credit Deflation

If banks are not lending for marco economic reasons - no demand from creditworthy borrowers, absence of creditworthy borrowers, or debt saturation and debt deflation (paying down or defaulting on debts, shrinking credit, contracting bank balance sheets) - lowering the fed funds rate by adding reserves will NOT spur lending or demand for loans, as long as lending standards remain unchanged or tighten.

Quantitative Easing

Quantitative Easing is an attempt to lower interest rates further out along the term structure of the yield curve (longer term interest rates).

This is done by creating new reserves (yes, out of nothing) and using them to buy longer term treasuries (or other longer term bonds like govt backed mortgages, which are in essence de facto treasuries, if the implicit backing is taken as explicit).

This action puts upward pressure on bond prices and downward pressure on bond yields (interest rates), while reducing the supply of bonds at that term of maturity on the market.

Tne consequential presence of excess reserves does not cause any new lending, nor do the lower rates cause new lending, per se.

The latter channel of QE's influence, via lending decisions at lower rates, is only effective at an extremely marginal level.

The former channel of influence is non existent, and has no impact. The extra reserves are merely a side effect of QE and have no impact on banks decisions to create credit.

As described above, banks manage their reserve position as an afterthought to their activity of creating credit. They acquire reserves at the end of an accounting period to meet their requirement, and the Fed always stands ready to provision whatever amount of reserves the banks in aggregate demand at whatever the Fed's target rate is.

The Fed allows the banks to create whatever credit the market demands at a given rate, and provides the banking system with whatever amount of reserves it needs at a given required reserve ratio.

Interest on Reserves

The presence of these excess reserves, as a side effect of QE, would drive down the fed funds rate to zero, in the absence of the Fed paying interest on reserves. The purpose of IOR policy is to set a floor on rates and maintain a positive overnight rate for the borrowing of reserves (Fed Funds).


In summary, then, there is no inherent limit to reserves in a fiat based monetary regime. The Fed accommodates the reserve demands of the private credit expansion (growing of loans, expanding bank balance sheets) at any given target rate.

Reserves do not enable or restrain lending in such a regime. Bank credit is ENDOGENOUS, and there is a great deal of academic literature on the nature of ENDOGENOUS MONEY. What endogenous means in this context, is that bank credit expansion LEADS the economic cycle, rather than following the Fed's reserve management.


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I read it all

A wants one credit,(or a loan with interest)
A creates IOU which B holds,(the promise to return a credit+interest)
B gives one credit to A,

then you lost me...

in the end A can't pay B back more than what exists;(only one credit)

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Cyril's picture

Maybe of interest, too : "Bunker Bear Kicks Keynesian Ass"

Maybe of interest, too :

Bunker Bear Kicks Keynesian Ass


"Cyril" pronounced "see real". I code stuff.


"To study and not think is a waste. To think and not study is dangerous." -- Confucius


i don't see nothin wrong, wit a lil BUMP n grind

this touches my heart.

this touches my heart.



“It is not our part to master all the tides of the world, but to do what is in us for the succour of those years wherein we are set, uprooting the evil in the fields that we know, so that those who live after may have clean earth to till." -J.R.R. Tolkien

its a bump on a post on a log

its a bump on a post on a log on the ground in a hole in the bottom of the sea.